Wednesday, March 07, 2012

John Carney Doesn't Understand Austrian Business Cycle Theory

John Carney at CNBC argues that the Austrian business cyle theory (ABCT) isn't applicable on the modern financial system using these arguments:

The MMTers would say that the Austrian view of fractional reserve banking is not really applicable in this day and age. The activity that Murray Rothbard described as “making loans out of thin air” and regarded as a form of counterfeiting is actually much more pervasive than he understood.

In the modern day and age, banks lend without regard to their reserves. The loan officer never calls the Federal Reserve to check whether reserves are adequate. Instead, banks make loans just the way other businesses invest in long-term projects—with an eye to profit. That is, banks lend according to their view of the likelihood of making a profit based on the risk factors of borrowers and the risk-premium the bank can charge them. Those new bank loans create new deposits in the banking system. 

Of course, bank loans do need to be financed in some way, because of the reserve requirements that banks must meet every other Wednesday. But a bank doesn’t need a depositor to drop by on Tuesday afternoon with a check or a new investor to arrive with a briefcase full of new capital. They can meet the reserve requirement by borrowing on the Fed Funds market. And there are always enough reserves to borrow because the bank created additional reserves by making the loan in the first place. In a pinch, they can borrow from the discount window of the Federal Reserve.

“Okay! Enough already! I get it,” the Austrian might reply. “Our banking system is even crazier than I imagined. What’s your point?”

The point is that interest rates no longer reflect savings rates. The interest rate signal is broken by the operations of the modern monetary system. Increases in savings don’t show up as falling interest rates, and decreases don’t show up as rising interest rates.

Carney is right that on many bank accounts these days, formal reserve requirements 
don't exist. What he is wrong about is its relevance for ABCT. Though reserve requirements have often been mentioned in some texts about ABCT, they are in no way something that ABCT logically presupposes. Reserve requirements or not, the Fed nevertheless controls interest rates, particularly at the short end of the maturity market.

And while it is true that interest rates in the modern monetary system don't reflect the natural savings rate, that fact doesn't contradict ABCT. Quite to the contrary, the whole point of ABCT is that business cycles are created by the Fed-controlled monetary system pushing down interest rates below its natural level.


Blogger Ralph Musgrave said...

I suggest it is fractional reserve that pushes interest rates to below their optimum level, rather than central banks. Reason is that what might be called “genuine savers” have to forgo consumption in order to release resources to enable themselves or anyone else to invest. In contrast, private banks can create savings out of thin air: no one (on the face of it) needs to forgo consumption in order to fund investments. Thus the interst charged by banks to create these pseudo savings will be lower than the rate charged by genuine savers.

But of course there is no such thing as a free lunch. The “savings” than banks create out of thin air are a mirage: that is, when those pseudo savings are spent, demand becomes excessive, thus demand has to reined in, i.e. a random selection of people are FORCED to forgo consumption.

As to central banks, they obviously fiddle around with interest rates, but I don’t see why that tends to result in artifically low rather than artificially high interest rates.

9:54 AM  

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